The information in this Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements, including, without limitation, statements relating to our revenues, expenses, margins, liquidity, capital needs and financing plans. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed elsewhere herein under the caption “Factors Affecting Future Results”.
The following table presents the percentages of net sales represented by certain line items from the Condensed Consolidated Statements of Operations for the periods indicated.
increases are primarily a result of sales of Larscom products and services. Total services revenue for the three months ended April 1, 2005 increased to $3,031,000 from $1,198,000 for the three months ended April 2, 2004, and total services revenue for the nine months ended April 1, 2005 increased to $8,547,000 from $1,863,000 for the same period of the prior year. These increases as compared to the prior year are attributable to the service businesses of XEL and Larscom.
Our business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to our top five customers decreased 13% in the three months ended April 1, 2005 to $9,289,000 from $10,635,000 in the comparable period in the prior year, and increased 5% in the nine months ended April 1, 2005 to $25,427,000 from $24,318,000 in the comparable period in the prior year. Net sales to all other customers increased by 51% and 74% in the three- and nine-month periods ended April 1, 2005, respectively, from the comparable periods in the prior fiscal year. Our top five customers did not remain the same over these periods. Sales to Verizon accounted for 44% of net sales in the three months ended April 1, 2005, as compared to 43% for the same period last year and accounted for 43% of net sales in the nine months ended April 1, 2005, as compared to 22% for the same period last year. While sales to Nortel accounted for 36% of the prior year’s sales for the nine months ended April 2, 2004, net sales to them during the nine months ended April 1, 2005 were less than 1% of net sales.
Gross Profit. Gross profit decreased to 28.8% of net sales for the three months ended April 1, 2005 as compared to 38.2% for the three months ended April 2, 2004. This decrease is attributable to a number of factors, including the change in product and services sales mix between the periods, the impact of the decline in sales of AS2000 products, additional inventory reserves provided against excess inventory and decreased pricing in certain areas. Gross profit decreased to 31.8% of net sales for the nine months ended April 1, 2005 as compared to 44.9% for the nine months ended April 2, 2004. This decrease is also attributable to a number of factors, including the change in product and services sales mix between the periods, the impact of the decline in sales of AS2000 products, additional inventory reserves provided against excess inventories, and to a lesser extent, decreased pricing in certain areas effective January 1, 2005. Gross profit in the three- and nine-month periods ended April 1, 2005 were reduced by $448,000 and $1,119,000, respectively, related to additional inventory reserves provided against excess inventories. Gross profit related to service revenues increased to 46.4% for the three months ended April 1, 2005 as compared to 37.1% for the three months ended April 2, 2004, and increased to 54.8% for the nine months ended April 1, 20054 from 42.6% for the nine months ended April 2, 2004, primarily due to the impact from the XEL and Larscom acquisitions. In the fourth quarter of fiscal 2005, we have planned product cost reductions that we expect to improve gross margins.
Research and Development. Research and development expenditures for the three months ended April 1, 2005 decreased 16% to $1,796,000 from $2,149,000 for the same period in the prior year, and decreased as a percentage of sales from 15.8% to 13.0%. Research and development expenditures for the nine months ended April 1, 2005 increased 16% to $5,792,000 from $4,981,000 for the same period in the prior year, and decreased as a percentage of sales from 15.4% to 14.7%. The decrease in spending for the three months ended April 1, 2005 compared to the same quarter in the prior fiscal year is a result of the reduction in staff from the consolidation of engineering in the Santa Barbara, California and Aurora, Colorado offices into our offices in Madison, Alabama and Newark, California. The increase in spending for the nine month period ended April 1, 2005 is primarily due to the addition of staff in connection with the acquisitions of XEL and Larscom offset by a reduction in staff due to consolidation efforts. Research and development expenses for the nine month period ended April 1, 2005 includes $139,000 related to compensation charges associated with retention bonus accruals and restricted stock awards. We believe that a significant level of investment in product development is required to remain competitive and that such expenses will vary over time as a percentage of net sales. However, we continue to monitor the level of our investment in research and development activities and adjust quarterly spending levels, upward or downward, based upon anticipated sales volume.
Selling, General and Administrative. Selling, general and administrative expenses for the three months ended April 1, 2005 increased 19% to $4,592,000 from $3,852,000 in the comparable period in the prior fiscal year and increased as a percentage of sales from 28.2% to 33.2%. Selling, general and administrative expenses for the nine months ended April 1, 2005 increased 67% to $13,920,000 from $8,340,000 in the comparable period in the prior fiscal year and increased as a percentage of sales from 25.8% to 35.4%. The increase over the same period in the prior year is primarily due to increased headcount and related expenses primarily attributable to the acquisitions of XEL and Larscom. Selling, general and administrative expenses for the three- and nine- months ended April 1, 2005 includes a total of $118,000 and $594,000, respectively, related to charges associated with acquisitions, consisting of compensation charges for retention bonuses, restricted stock awards, and other direct acquisition related expenses. Based on our review of spending levels, we expect overall selling, general and administrative expenses for the fourth quarter of fiscal 2005 to decrease due to lower headcount and spending targets.
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Amortization of Acquired Intangible Assets. Amortization of acquired intangible assets for the three- and nine- months ended April 1, 2005 totaled $645,000 and $1,901,000, respectively, as compared to $265,000 and $713,000 for the comparable periods of the prior fiscal year.
Impairment Charge Related to Goodwill. During the three months ended October 1, 2004, we completed an interim test for the impairment of goodwill and determined that the carrying value was impaired. Therefore, we recorded an impairment charge related to goodwill in the amount of $19,984,000. (See Note 6 to Notes to the Condensed Consolidated Financial Statements)
Restructuring Charges. During the three months ended October 1, 2004, we announced plans to consolidate our engineering functions into two locations and to consolidate certain Larscom manufacturing and administrative functions in Newark, California to our Madison, Alabama facility. These restructuring activities, along with restructuring activities announced in prior quarters, are described in more detail in Note 9 to Notes to the Condensed Consolidated Financial Statements. We recorded net charges (credits) related to restructuring activities for the three- and nine-month periods ended April 1, 2005 totaling $(42,000) and $692,000, respectively. The restructuring charge in the three months ended April 1, 2005 was reduced by $42,000 for a reduction in the restructuring accrual assumed in the Larscom consolidation to adjust severance and related costs for changes in the employment status of certain employees. These restructuring activities were substantially completed during the quarter ended December 31, 2004.
Interest and Other Income, Net. Interest and other income, net increased 185% to $624,000 for the three months ended April 1, 2005 from $219,000 and increased 57% to $995,000 for the nine months ended April 1, 2005 from $635,000 in the comparable period in the prior fiscal year due to (i) the change in fair value of warrants issued in connection with the senior convertible notes, which resulted in other income during the quarter of $528,000, (ii) offset by lower interest income on lower average investment balances during the period. Rental income, net of expenses, is included in interest and other income, net and totaled $135,000 and $406,000 in the three- and nine-month periods ended April 1, 2005 and April 2, 2004, respectively.
Interest Expense. Interest expense increased 27% to $188,000 for the three months ended April; 1, 2005 from $148,000 and increased 94% to $428,000 for the nine months ended April 1, 2005 from $221,000 in the same period in the prior fiscal year as a result of (i) interest on the convertible notes issued in connection with the acquisition of XEL in February 2004, (ii) interest paid on borrowings under our RBC line of credit from April 2004 through March 2005, which was terminated on March 21, 2005, and (iii) total interest charges related to the $10,000,000 in senior convertible notes issued on March 21, 2005.
Provision for Income Taxes. No tax provision or tax benefits were recognized for the three- or nine-month periods ended April 1, 2005 or April 2, 2004, due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, we established a full valuation allowance against our deferred tax assets due to the net operating loss carry forwards from prior years and the operating losses incurred in fiscal 2001.
Net Income (Loss). Net loss for the three months ended April 1, 2005 was $2,574,000 compared to $1,388,000 for the three months ended April 2, 2004. Net loss for the nine months ended April 1, 2005 was $29,204,000 compared to net income of $512,000 for the nine months ended April 2, 2004. The changes between the periods are a result of the above factors, primarily due to the impairment charge related to goodwill, the increase in selling, general and administrative expenses, the increase in amortization of acquired intangible assets and the decrease in the gross margin percentage between the periods. Net loss as a percentage of sales for the three months ended April 1, 2005 was (18.6)%, compared to (10.2)% for the three months ended April 2, 2004. Net loss as a percentage of sales for the nine months ended April 1, 2005 was (74.2)%, compared to net income as a percentage of sales of 1.6% for the nine months ended April 2, 2004.
LIQUIDITY AND CAPITAL RESOURCES
On April 1, 2005, our principal source of liquidity included $4,881,000 of unrestricted cash and cash equivalents.
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Cash Flows
During the nine months ended April 1, 2005, cash used in operating activities was $8,106,000 compared to cash provided by operating activities of $3,010,000 for the nine months ended April 2, 2004. Net cash used in operating activities in the current period was primarily due to (i) the net loss before depreciation and amortization, amortization of deferred compensation and impairment charge related to goodwill, which totaled $5,694,000 and (ii) the net change of other assets and liabilities, which totaled $1,764,000. The increase of accounts receivable between the beginning and end of the period includes receivables contributed by Larscom. However, the change in accounts receivable for the current period provided cash of $295,000 in the nine months ended April 1, 2005 compared to $3,094,000 used in the comparable period in the prior fiscal year. The increase in inventories was again the result of inventory acquired in the Larscom acquisition. Otherwise, inventory provided $1,776,000 of cash in the nine months ended April 1, 2005 compared to cash provided in the same period last year of $318,000. Accounts payable and accrued expenses used $5,076,000 of cash in the nine months ended April 1, 2005 compared to providing cash of $2,947,000 in the comparable period in the prior fiscal year. The changes in accounts payable and accrued expenses for the nine months ended April 1, 2005 and the comparable prior year period were due to the timing of inventory purchases and the resulting payments to vendors, restructuring reserves, the impact of the Larscom acquisition and the increased sales volume in the current year.
Cash provided by investing activities was $2,980,000 for the nine months ended April 1, 2005 compared to cash used in investing activities of $9,119,000 for the nine months ended April 2, 2004. The funds provided in investing activities during the nine months ended April 1, 2005 are the results of net cash acquired in the Larscom acquisition of $5,292,000 offset by cash expenses relating to the acquisition of $1,300,000, current year payments related to the NetEngine and Miniplex product line acquisitions totaling $709,000, and capital expenditures of $303,000. Funds used in investing activities during the nine months ended April 2, 2004 are a result of payments related to the NetEngine and Miniplex product line acquisitions of $1,181,000, the XEL acquisition of $7,612,000, capital expenditures of $540,000 and the purchase of short-term investments of $26,000, offset by proceeds from the repayment of notes receivable of $240,000.
Cash provided by financing activities was $6,566,000 for the nine months ended April 1, 2005 and $483,000 for the nine months ended April 2, 2004. Funds provided by financing activities during the nine months ended April 1, 2005 resulted from borrowings under our line of credit and issuance of convertible notes, net of cash expenses, totaling $10,447,000 and proceeds from the issuance of common stock under our stock plans of $196,000, offset by payments on long-term debt, capital lease obligations and payoff of the line of credit with RBC totaling $3,883,000 and the purchase of treasury shares totaling $194,000 related to tax withholdings on restricted stock awards that vested during the period. Proceeds from the issuance of common stock under our stock plans provided $1,031,000 of cash and payments on long-term debt and capital lease obligations used cash of $548,000 for the nine months ended April 2, 2004.
Senior Convertible Notes
In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at an initial price of $3.01 per share. The conversion price of the senior convertible notes will be subject to weighted average anti-dilution adjustments. The senior convertible notes may not be converted into more than 20% of the number of shares or voting power of our common stock outstanding as of the closing of the financing until such conversion or exercise has been approved by our stockholders. As of April 1, 2005, a total of $10,000,000 in face value of senior convertible notes was outstanding. These senior convertible notes are recorded in the condensed consolidated balance sheet at April 1, 2005, at the discounted amount of $7,176,000. As provided in the securities purchase agreement, we used $3,500,000 of the proceeds from these senior convertible notes to repay and terminate the line of credit with RBC.
The senior convertible notes bear interest at a rate of six percent per annum and are repayable in ten quarterly installments beginning in July 2005, or earlier upon the occurrence of certain events. Payment of both principal and interest may be made in either cash or, provided that we have obtained stockholder approval to the extent necessary, by the delivery of shares of common stock at a price equal to the lower of (i) the conversion price of $3.01 or (ii) 90% of the weighted average sale price of our common stock for the fifteen consecutive trading days ending on the fourth trading day immediately preceding the applicable interest or installment payment date. Such issuance of common stock will not result in anti-dilution adjustments to the conversion price of the senior convertible notes. If by November 21, 2005, we have not obtained stockholder approval of the issuance of the senior convertible notes, the warrants and the shares of common stock to be
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issued thereunder and an increase in our authorized capital of at least 10,000,000 shares of common stock, we will be required to make at least 50% of interest and installment payments made after such date in cash. If, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements, the holders of the senior convertible notes may require us to make an additional installment payment under the senior convertible notes which shall be, at the option of each holder, such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Substantially all of our assets are pledged as collateral for amounts outstanding under the senior convertible notes.
At April 1, 2005, “tested working capital”, as defined in the senior convertible notes, was $8,244,000. If we fail to maintain tested working capital of at least $8,000,000 at the end of each fiscal quarter in which amounts are outstanding under the senior convertible notes, the holders of the senior convertible notes may require us to make an additional special installment payment under these notes as described above.
Convertible Promissory Notes
In February 2004, we issued two convertible promissory notes totaling $10,480,000 in connection with our acquisition of XEL Communications, Inc. In May 2004, the holder of the $10,000,000 convertible promissory note converted $7,250,000 of the outstanding principal amount of the note into 1,361,758 shares of our common stock. These convertible promissory notes earn interest at a rate of 7% per annum and mature February 5, 2006. The holders may convert the note in whole or in increments of at least $1,000,000 into our common stock at a conversion price of $5.324 per share. As of April 1, 2005, the amount outstanding under the convertible promissory notes totaled $2,880,000.
Line of Credit
As noted above, the line of credit with RBC was repaid and the loan and security agreement terminated on March 21, 2005 in connection with the issuance of the senior convertible notes. The interest on outstanding borrowings under this line was at a rate of 250 basis points over the 30-day London inter-bank offered rate. All of our assets, other than the property subject to lease and restricted cash, were pledged as collateral securing amounts outstanding under this line.
Mortgaged Property Held for Sale
The final balloon payment of approximately $3,065,000 is due on February 1, 2006 on a note secured by our facility leased to The Boeing Company located at 950 Explorer Boulevard in Huntsville, Alabama. We continue to seek a buyer for this facility, which represents a potential source of additional cash that may be used to partially fund our commitments. We may not, however, be able to complete a sale of the property on a timely basis or on favorable terms to us.
Liquidity Generally
We have prepared for reduced legacy sales through acquisitions, by investment in next generation broadband access products, and the alignment of our operating costs with management’s revenue expectations in light of current conditions in the telecommunications industry. On a quarterly basis, management evaluates the revenue outlook and adjusts spending levels as necessary.
The accompanying financial statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business and do not reflect adjustments that might result if we were not to continue as a going concern. The auditor’s report on our financial statements as of July 2, 2004 contains an explanatory paragraph, which refers to uncertain revenue streams and a low level of liquidity and notes that these matters raise substantial doubt about our ability to continue as a going concern.
In connection with our acquisition of the Miniplex product line, we agreed to purchase the seller’s Miniplex related inventories totaling approximately $2,100,000 on the earlier of the date used by us or December 31, 2004. The remaining purchase commitment of $776,000 is included in inventories and accounts payable on the consolidated balance sheet as of April 1, 2005.
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We believe that our cash and cash equivalents, cash flow from operations, and anticipated proceeds from the sale of the facility located at 950 Explorer Boulevard, Huntsville, Alabama will be sufficient to fund our operations through the next twelve months. However, if the facility is not sold or is sold for substantially less than the appraised value, we will need other sources of credit or financing in early calendar 2006 to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. If additional credit or other financing is not available as needed or on terms acceptable to us, we may seek to renegotiate certain of our contractual obligations.
ACQUISITION OF LARSCOM INCORPORATED
On July 28, 2004, we completed our acquisition of Larscom and issued approximately 5,948,652 shares of our Common Stock for all the outstanding stock of Larscom. Additionally, we assumed all outstanding stock options and warrants of Larscom. Larscom manufactures and markets high-speed network-access products for telecommunication service providers and corporate enterprise users. This acquisition reflects our strategy to pursue revenue growth, and brings a complementary customer base and product synergies
The acquisition was recorded under the purchase method of accounting in the first quarter of fiscal 2005, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The goodwill recorded as a result of the acquisition will not be amortized but will be included in our annual review of goodwill for impairment. A summary of the total purchase consideration is as follows:
Value of common stock issued | | $ | 26,043 | |
Value of options and warrants assumed | | | 516 | |
Direct transactions costs | | | 1,300 | |
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Total purchase consideration | | $ | 27,859 | |
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CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods might be based upon amounts that differ from those estimates. The following represent what we believe are among the critical accounting policies most affected by significant management estimates and judgments:
Accounting for Acquisitions: We account for acquisitions as a purchase in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations. As such, we report all acquired tangible and intangible assets and liabilities at fair value. We recognize the fair value of the purchased intangible assets as operating expenses over the estimated useful life of each separate intangible asset. We recognize the fair value associated with any in-process technology as an operating expense in the period an acquisition is consummated. We value any employee stock options assumed as part of the acquisition using the Black-Scholes valuation model. The value of assumed vested options and the value of assumed unvested options in excess of the intrinsic value of such unvested options are included as part of the purchase price consideration. We report the intrinsic value of any unvested options as deferred compensation and record it as an operating expense over the remaining vesting period of the options. We value our stock issued as part of the consideration using the 5-day average price surrounding the date the acquisition was announced.
Impairment of Long-Lived Assets and Goodwill. We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 144. Our long-lived assets include, but are not limited to, the property held for lease located at 950 Explorer Boulevard in Huntsville, Alabama, related furniture and equipment, software licenses, and intangible assets related to acquisitions.
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We assess the impairment of goodwill at least annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 142. Due to circumstances that occurred during the first quarter of fiscal 2005, we completed a test for impairment of goodwill. These circumstances include the loss of product revenues from a significant customer, the low level of liquidity noted in the going concern opinion issued late in the quarter on our fiscal 2004 consolidated financial statements and the low market price of our common stock following the end of the first quarter. Based on this review, we determined that the carrying value of our goodwill was impaired and recorded an impairment charge related to goodwill of $19,984,000. The impairment charge was based on a projected discounted cash flow model using a discount rate commensurate with the risk inherent in our current business model.
Prior to the first quarter of fiscal 2005, we utilized a fair value model that compared our carrying value of our equity to our market capitalization calculated by multiplying our outstanding shares by our current share price disregarding anomalies in share price that it deemed were temporary in nature. Due to the changes in facts and circumstances caused by the loss of product revenues from a significant customer, the significant volatility in our share price from the end of our 2004 fiscal year through the filing of our Quarterly Report on Form 10-Q for the first quarter of fiscal 2005, and our low level of liquidity, we evaluated the results of multiple fair value models and all available data points and concluded that the fair value calculated from a projected discounted cash flow model is a better indication of our fair value, as that term is contemplated in SFAS 142, Goodwill and Other Intangibles, than the market capitalization model used historically.
Inventories. We value inventory at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventory quantities on hand are reviewed on a quarterly basis and a provision for excess and obsolete inventory is recorded based primarily on our estimated forecast of product demand for the next twelve months. Management’s estimates of future product demand may prove to be inaccurate, in which case we may increase or decrease the provision required for excess and obsolete inventory in future periods. During the first three quarters of fiscal 2005, we recorded additional inventory reserves related to excess inventories, primarily due to our assumption that Nortel may not purchase additional AS2000 inventory on hand and a change in the product mix we experienced regarding the forecast for future sales of products acquired in the Larscom acquisition. Inventory reserves totaled $8,426,000 and $3,316,000 as of April 1, 2005 and July 2, 2004, respectively.
Revenue Recognition. We recognize a sale when persuasive evidence of an arrangement exists, the product has been delivered or services have been performed, the price to the purchaser is fixed or determinable, and collection of the resulting receivable is reasonably assured. A reserve for future product returns is established at the time of the sale based on historical return rates and return policies, including stock rotation for sales to distributors that stock our products. The reserve for future product returns was $560,000 and $313,000 as of April 1, 2005 and July 2, 2004, respectively. Service revenue earned from providing maintenance, installation, training or other miscellaneous services is recognized when those services are provided to the customer, if there is persuasive evidence of an arrangement, the fee is fixed and determinable and collection of the receivable is reasonably assured.
Warranty Provision. We record a warranty provision at the time of the sale based on our best estimate of the amounts necessary to settle future claims on products sold. While we believe that our warranty reserve is adequate and that the judgment applied is appropriate, actual product failure rates, material usage or other rework costs could differ from our estimates, which could result in revisions to our warranty liability that totaled $2,127,000 and $1,192,000 as of April 1, 2005 and July 2, 2004, respectively.
Allowance for Doubtful Accounts. We estimate losses resulting from the inability of our customers to make payments for amounts billed. The collectibility of outstanding invoices is continually assessed. Assumptions are made regarding the customer’s ability and intent to pay, and are based on historical trends, general economic conditions and current customer data. Should our actual experience with respect to collections differ from these assessments, there could be adjustments to our allowance for doubtful accounts, which totaled $1,300,000 and $536,000 as of April 1, 2005 and July 2, 2004, respectively.
Restructuring Reserves. Restructuring reserves are based on estimates of the salary and benefit obligations to terminated employees, amounts necessary to write off assets no longer utilized by us and for contractual payments we expect to continue to make for property no longer in use. Although we do not anticipate significant changes, the actual costs may differ from these estimates. Restructuring reserves totaled $1,136,000 and $390,000 as of April 1, 2005 and July 2, 2004, respectively.
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Deferred Tax Assets. We have provided a full valuation reserve related to our deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets and assesses the need for the valuation allowance each quarter. The valuation allowance related to our deferred tax assets was $16,783,000 as of July 2, 2004.
Factors Affecting Future Results
As described by the following factors, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “may”, “will”, “expects”, “plans”, “anticipates”, “estimates”, “potential”, or “continue”, or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements include statements regarding: the adequacy of our liquidity and capital resources for the next twelve months; the potential need to obtain credit or other financing or to renegotiate contractual obligations; the sale of our facility at 950 Explorer Boulevard in Huntsville, Alabama; satisfaction of future financial obligations, including the senior convertible notes, convertible promissory notes, and note payable on real estate; growth of our market segments; improvement in gross margins; selling, general and administrative expenses; research and development expenditures; total budgeted capital expenditures; anticipated decline in sales of legacy products; engineering consolidation plans; payment of lease obligations by our subtenants; and the impact of recently issued accounting pronouncements. These forward-looking statements involve risks and uncertainties, and it is important to note that our actual results could differ materially from those in such forward-looking statements. Among the factors that could cause actual results to differ materially are the factors detailed below and in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, as well as the other factors set forth in Item 2 hereof. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement or risk factor. The risk factors described herein should be read in conjunction with the risk factors more fully discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.
• | Our Indebtedness and Debt Service Obligations May Adversely Affect Our Cash Flow. Should we be unable to satisfy our interest and installment payment obligations under our outstanding convertible notes by the payment of shares of common stock, we will be required to pay those obligations in cash. If we are unable to generate sufficient cash to meet these obligations, we may have to restructure or severally limit our operations. Our indebtedness could have significant additional negative consequences, including, but not limited to: (i) requiring the dedication of a substantial portion of the our expected cash flow from operations to service the indebtedness, thereby reducing the amount of expected cash flow available for other purposes, including capital expenditures, (ii) increasing our vulnerability to general adverse economic and industry conditions, (iii) limiting our ability to obtain additional financing, (v) limiting our flexibility to plan for, or react to, changes in its business and the industry in which it competes, and (vi) placing us at a possible competitive disadvantage to competitors with less debt obligations and competitors that have better access to capital resources. |
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• | Issuance of the Shares of Common Stock Upon Conversion or Repayment of Senior Convertible Notes, Payment of Interest, and Exercise of Warrants Will Dilute The Ownership Interest of Existing Stockholders and Could Adversely Affect The Market Price of Our Common Stock. In connection with the securities purchase agreement, we may issue shares of common stock to the investors (i) upon conversion of some or all of the senior convertible notes (including notes issuable upon exercise of the additional investment rights), (ii) in satisfaction of our installment obligations under the notes, (iii) in satisfaction of our interest obligations under the notes, and (iv) upon exercise of the warrants. Any of these issuances will dilute the ownership interests of existing stockholders. Any sales in the public market of this common stock could adversely affect prevailing market prices of the common stock. In addition, the existence of these notes and warrants may encourage short selling by market participants. |
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• | The Senior Convertible Notes Provide That Upon The Occurrence of Various Events of Default and Change of Control Transactions, The Holders Would Be Entitled To Require Us To Redeem The Notes For Cash, Which Could Leave Us With Little or No Working Capital for Operations or Capital Expenditures. The senior convertible notes allow the holders to require redemption of the notes upon the occurrence of various events of default, such as the termination of |
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| trading of our common stock on the Nasdaq National Market, or specified change of control transactions. In such a situation, we may be required to redeem all or part of the notes, including any accrued interest and penalties, within 5 business days after receipt of a demand for such redemption. Some of the events of default include matters over which we may have some, little or no control. If an event of default or a change of control occurs, we may be unable to pay the full redemption price in cash. Even if we were able to pay the redemption price in cash, any such redemption could leave us with little or no working capital for our business. We have not established a sinking fund for payment of our obligations under the notes, nor do we anticipate doing so. |
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• | If We Cannot Obtain The Required Stockholder Approval To Issue Common Stock in Satisfaction of Our Interest and Installment Obligations Under The Senior Convertible Notes, We Must Satisfy at Least 50% of These Obligations In Cash. After November 21, 2005, stockholder approval will be required for us to make certain interest and installment payments under the senior convertible notes with shares of common stock. In the event that stockholder approval is not obtained by this date, we will be required to make at least 50% of such interest and installment payments in cash. Any such payments could leave us with insufficient working capital for our business. |
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• | The Senior Convertible Notes Are Secured by Substantially All of Our Assets. The investors in our private placement received a security interest in and a lien on substantially all of our assets, including our existing and future accounts receivable, cash, general intangibles (including intellectual property) and equipment. As a result of this security interest and lien, if we fail to meet our payment or other obligations under the notes, the investors would be entitled to foreclose on and liquidate substantially all of our assets. Under those circumstances, we may not have sufficient funds to service our day-to-day operational needs. Any foreclosure by the investors in the private placement would have a material adverse effect on our financial condition. |
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• | If Tested Working Capital Falls Below Certain Defined Levels, We May Be Required To Make Additional Payments To The Holders Of The Senior Convertible Notes. We may be required to make additional payments under the senior convertible notes if, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements. In that event, we must provide notice of the working capital deficiency to the noteholders on the date of our quarterly results announcement. For a period of seven business days after our notice to the noteholders, each holder may provide us a notice requiring us to pay such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Our payment of these additional amounts may be in cash and/or common stock pursuant to similar terms as the payment of regular installment amounts. Any requirement that we make any such payments in cash could leave us with insufficient working capital for our business. |
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• | Liquidity in General and Need for Additional Financing. We may need other sources of financing or credit to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. To the extent our results of operations do not substantially meet our operating plan, or the facility located at 950 Explorer Boulevard, Huntsville, Alabama is not sold or is sold substantially below its appraised value, or additional working capital is needed to support growth, credit or other financing may be needed in greater amounts or earlier than otherwise. If additional funds are raised through the issuance of equity securities, the percentage of equity ownership of our existing stockholders will be reduced. If additional funds are raised through the issuance of debt securities, we may incur significant interest charges, and these securities would have rights, preferences and privileges senior to holders of common stock. The terms of these securities could also impose restrictions on our operations. Additional credit or other financing may not be available when needed or on terms favorable to us or at all. |
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• | Independent Registered Public Accounting Firm’s Report Includes a “Going Concern” Explanatory Paragraph. Our independent registered public accounting firm included in its report on our consolidated financial statements for the fiscal year ended July 2, 2004, a going concern explanatory paragraph, which states that we have uncertain revenue streams and a low level of liquidity that raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to obtain adequate financing and achieve a level of revenues and cash flow adequate to support our capital and operating requirements. |
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• | Evolving Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses and Continuing Uncertainty. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules are creating uncertainty for public companies. We continually evaluate and monitor developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we have invested resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and we may be harmed. |
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• | When We Adopt FAS 123R Related to the Accounting for Employee Stock Option and Employee Stock Purchase Plans Using a Fair-Value Method, Our Results from Operations and Earnings Per Share Will Be Reduced Significantly. The Financial Accounting Standards Board recently issued SFAS No. 123R “Share-Based Payment” (“FAS 123R”). FAS 123R requires companies to measure all stock-based compensation awards using a fair-value method and record such expense in their consolidated financial statements. FAS 123R is effective beginning our first quarter of fiscal 2006. We are currently assessing the impact of FAS 123R on our stock-based compensation programs; however, we expect to record significant stock-based compensation expense that will reduce our net income (loss) and earnings per share. When we are required to treat all stock-based compensation as an expense, we may change both our cash and stock-based compensation practices. |
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• | Dependence on Legacy and Recently Introduced Products and New Product Development. In prior years, the majority of sales have been provided by our legacy products, primarily the AS2000 product line. We have planned for some time for the eventual decline in sales of legacy products. Sales of the AS2000 have significantly declined in fiscal 2005 and are expected to further decline in the future. While we believe we have positioned Verilink to offset the loss of legacy sales over the long-term, reduced legacy sales will impact our results of operations in the near-term, and sales of new products will often be at lower margins than legacy sales. Our future results of operations are dependent on market acceptance of existing and future applications for our existing products and new products in development. |
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• | Risks Associated With Acquisitions, Potential Acquisitions and Joint Ventures. One element of our strategy is to consider acquisition prospects and joint venture opportunities. Acquisitions of this nature by us could result in potentially dilutive issuance of equity securities, use of cash, the incurring of debt and the assumption of contingent liabilities, significant demands on management attention, and/or business risks associated with integrating other businesses into us, any of which could have a material adverse effect on our business and operating results and/or the price of our common stock. |
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• | Customer Concentration. A small number of customers have historically accounted for a majority of our sales, with a single customer’s orders for legacy products accounting for a majority of sales in many fiscal quarters. There can be no assurance that our current customers will continue to place orders with us, that orders by existing customers will continue at the levels of previous periods, or that we will be able to obtain orders from new customers. |
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• | Dependence on Key Personnel. Our future success will depend to a large extent on the continued contributions of our executive officers and key management, sales, marketing and technical personnel. In the second quarter of fiscal 2005, we implemented a temporary salary reduction program to conserve cash together with special equity incentive grants. Our current financial condition and salary reductions may make it more difficult to attract and retain key personnel. |
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• | Dependence on Key Suppliers and Component Availability. The loss of a key supplier, loss of a contract manufacturer, an increase in required lead times, adverse change in payment practices or other terms and conditions, an increase in prices of component parts, interruptions in the supply of any components, our inability or our third party sub-contractor to procure components from alternative sources at acceptable prices and within a reasonable time, could have a material adverse effect upon our business, financial condition and results of operations. |
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• | Potential Volatility of Stock Price. The trading price of our Common Stock has been and may continue to be subject to wide fluctuations in response to quarter-to-quarter variations in operating results, announcements of technological innovations or new products by us or our competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, changes in earnings estimates by analysts, or other events or factors. |
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• | Competition. The market for telecommunications network access equipment addressed by our product families can be characterized as highly competitive, with intensive price pressure. Many of our current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than us, and many have long-established relationships with network service providers. |
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• | Rapid Technological Change. The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. Our business, financial condition and results of operations would be materially adversely affected if we were to be unsuccessful, or to incur significant delays in developing and introducing new products or enhancements. |
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• | Compliance with Regulations and Evolving Industry Standards. The market for our products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. The failure of our products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of our products. |
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• | Risks Associated With Entry into International Markets. Historically, we have little experience in International markets, but are expanding sales of our products outside of North America and expect to grow certain international markets, which will require significant management attention and financial resources. Conducting business outside of North America is subject to certain risks, including longer payment cycles, higher costs, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in receivables collection and potentially adverse tax consequences. |
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• | Risk of Third Party Claims of Infringement; Limited Protection of Intellectual Property. The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. In the event of a successful claim against us and our failure to develop or license a substitute technology, our business, financial condition and results of operations could be materially adversely affected. We rely upon a combination of statutory and contractual restrictions to establish and protect proprietary rights in our products and technologies. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of our technologies or discourage independent third-party development of similar technologies. |
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
We are subject to interest rate risks on the long-term debt secured by our property located at 950 Explorer Boulevard, Huntsville, Alabama. If market interest rates were to increase immediately and uniformly by 10% from levels as of April 1, 2005, the additional interest expense would not be material. We believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows would not be material.
Item 4. Controls and Procedures.
(a) Evaluation of disclosure controls and procedures. Based on their evaluation as of April 1, 2005, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
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(b) Changes in internal control over financial reporting. There were no significant changes in our internal control over financial reporting identified in management’s evaluation during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 6. Exhibits
(a) | Exhibits Index: | | |
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| Exhibit Number | | Description of Exhibit |
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| 31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 |
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| 31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 |
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| 32.1 | | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| VERILINK CORPORATION |
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May 10, 2005 | By: | /s/ TIMOTHY R. ANDERSON |
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| | Timothy R. Anderson |
| | Vice President and Chief Financial Officer |
| | (Principal Financial and Accounting Officer) |
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